Pentagon, Contractors Clash Over Profits

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By Sandra I. Erwin

The pressure is on at the Pentagon to bring down the cost of military hardware. The dictum from acquisitions chief Frank Kendall is that “unaffordable” programs will be axed.

As expected, the scramble to slash costs is fueling tension and finger pointing between government officials and contractors. In a budget climate where the future is uncertain, relations between buyers and sellers appear to have hit rock bottom.

A sense of distrust from both sides was on display during a recent industry conference when Air Force Maj. Gen. Wendy Masiello, deputy assistant secretary for contracting, suggested that companies are making too much money on defense work and that some of that wealth should be returned to the taxpayers. After one industry executive asked her to elaborate, Masiello responded: “I’m not looking at taking money out of your pocket. But I have an obligation to make sure that what I’m paying is a fair and reasonable price.”

The Air Force is in a fiscal straightjacket. This year alone, it is more than $12 billion short of what it needs to pay its bills. At the same time, as Masiello noted, “Every day we read in the paper that the defense industry is still doing pretty well financially. … We have to figure out how to get a share of that.”

Masiello has ruffled feathers in industry circles for questioning some of the Air Force’s long-term contracts for the maintenance of weapon systems. She has challenged contractors to disclose their financial data so the government can see exactly how much money a company earns from a deal. Some firms find that level of scrutiny excessive, as long as they are delivering the products and services the government is seeking at agreed-upon prices.

Kendall and other senior Pentagon leaders have frequently reassured industry CEOs that there is no “war on profits.”

But the tension is palpable. In today’s contracting world, there is little trust in negotiations, said Lt. Gen. Charles R. Davis, the Air Force’s top military acquisitions official. “We are all focused on trying to shift the risk somewhere else,” he said. “We are often very suspect of each others’ motivations. When money was flowing freely, there was less pressure on government program officers to squeeze industry for a better deal. Things are different now.”

Davis clearly gets the irony of being a U.S. military officer who is challenging corporate profits.

“These are wonderful elements of capitalism that we [the armed forces] try to defend every day,” he said at a conference hosted by Credit Suisse and McAleese & Associates.

Davis suggested there should be a better way to protect the collective interests of government and industry. But nobody has yet come up with a winning strategy for how to do that.

In the face of a shrinking bank account, Defense Department contracting officials are becoming unhappy with contractors who seem to have figured out ways to make more profit than the government thinks they should.

“I need to understand the cost and the resulting profit,” Masiello said. “It’s a little scary that we’ve never had that kind of insight. It can be a little threatening that they figured out how to make a lot more money and return on that investment than the government might have been reaping in that process.”

As Masiello spoke, she raised eyebrows in the audience. “That is not how free enterprise works,” whispered one executive.

Although the idea that a highly regulated defense industry is a free market might be a stretch, companies believe that they should be given incentives to make money, and that corporate efficiencies are ultimately returned to the customer via lower prices.

Masiello said she understands that concept, but she is still not certain that the government always gets a fair shake. “You are trying to make more profits and be more efficient. I want a little bit of that cut.”

The Pentagon’s latest procurement policy guidance, called Better Buying Power 2.0, might have unintentionally stirred up acrimony by recommending that buyers use, whenever possible, fixed-price contracts, which force the vendor to agree to a price upfront and absorb any future cost overruns. Such deals seem like a sure win for the government, but their misuse can backfire. The Pentagon has seen a hit parade of failed programs, including the infamous A-12 bomber, that were set up as fixed-price deals.

Following the release of BBP 2.0 and a subsequent uproar from industry, Kendall sought to roll back the emphasis on fixed-price contracting, in favor of agreements that provide incentives for industry to lower costs and that make sense for the particular product or service.

In another high-profile case of Pentagon buyers publicly shaming contractors, Lt. Gen. Christopher C. Bogdan, program executive officer of the Joint Strike Fighter, made worldwide headlines when he accused prime contractors Lockheed Martin Corp. and Pratt & Whitney of not helping him bring down the JSF’s spiraling price tag.

Bogdan later noted that he had spoken out of frustration and that, following some blunt discussions with senior company executives, he had confidence that the contractors were moving in the right direction. But Bogdan made it known that it was not until the government forced Lockheed to bear more risk that the cost and schedule trends started improving. In the latest low-rate production contract for JSF, the Pentagon is holding Lockheed responsible for 50 percent of the overruns. “Guess what happens when a contractor’s skin is in the game? Things improve magically sometimes,” said Bogdan.

Frank Cappuccio, a defense industry consultant and former executive vice president of Lockheed Martin, recalled a time when the Pentagon and contractors had a friendlier rapport. He noted that under the contract the Air Force signed with Lockheed for the maintenance of the F-117 stealth fighter, the company agreed to split the extra profits with the government. “I do believe the U.S. government and defense industry have to form a partnership,” he told National Defense. “But I think it has to be a valid partnership” where the risk is borne by both in an equitable way.

What is happening now, he said, is the government wanting to have it both ways with fixed-price contracts: If industry makes money unexpectedly, the Pentagon wants part of it. But if contractors overrun, it is too bad for them.

The key is to negotiate upfront, he said. Companies are not going to voluntarily surrender profits if it’s not written in the contract. “Once industry is given an incentive to save, they find a way to do it.”

Given the charged atmosphere today, the prospect of closer partnerships appears dim.“We are trying to not get entrenched into an ‘us-versus-them’” stance, Masiello said. “But we are all faced with this budget environment.”

Re: Pentagon, Contractors Clash Over Profits

One of my colleagues read my comments and added a few of his own from within. These comments are a perfect compliment to fixing an ongoing problem that hurts us all. If we are going to truly solve these problems for love of country, a sense of fair play and genuine cost saving we all have to share our constructive perspectives such as those below

Amen.There are other parties to the madness--besides the PMs and corporate muppets. There's also the lawyers ("you MUST do it this way and CAN'T tell them this or that") and Congress (no, you can't have a multi-year contract...we want to mess with you EVERY year...even though that raises the costs to the taxpayers!)

Christopher Baxter on 04/15/2013 at 15:40

Re: Pentagon, Contractors Clash Over Profits

This was a corrected better copy

To do this properly, it really does have to be a team effort and both parties have to define their expectations going in from the beginning, I grew up as "one of the people in the field" and relate well to both ends . As a tax payer I don't accept the “$600.00 toilet seat” engineered by “corporate Muppets” , nor to I accept agreeing to a price and then having mission creep in the program which could change the cost of a project or program and leave the contractor not only with nothing, but also a complete loss. Or, agreeing to parameters which are un-workable or un-businesslike from the outset. In this case it is fair to say such an equivalent disaster is “engineered by “Contracting Muppet”. In both cases “Muppets” are “bad people!”. There must be accountability on both parts of the equation, buy people who conduct themselves as consummate "career professionals"; as ladies & gentlemen and not individuals who treat their counterparts as "adversaries" or as "disposable". When you treat another person as disposable, eventually you become disposable yourself. I like what Leonard Lee of Lee Valley tools said ( and this applies both ways in a genuine relationship): You treat a customer like a friend, but the idea that "the customer is always right is a bunch of crap". You may ask why? Because we are all human and all capable of mistakes. When we make one, own up to it, fix it and move on instead of behaving like a bad seven year old with attitude that really needs a spanking.

Equally, people in the companies have to accept responsibility for their decisions, and as do people in government. The person or people making the decisions have to accept responsibility, otherwise we have unaccountability and possible anarchy. While diplomacy is important, in cases such as this, so is calling" a spade a spade" when you see one and not pussy footing or dancing around the core of a problem.

I could write a book or article on this subject, but I have to get back to work, carrying out some of the same basic principles noted above.

Christopher Baxter on 04/14/2013 at 21:52

Re: Pentagon, Contractors Clash Over Profits

To do this properly, it really does have to be a team effort and both parties have to define their expectations going in from the beginning. As a tax payer I don't accept the “$600.00 toilet seat” engineered by “corporate Muppets” , nor to I accept agreeing to a price and then having mission creep in the program which could change the cost of a project or program and leave the contractor not only with nothing, but also a complete loss. In this case it is fair to say such an equivalent disaster is “engineered by “Contracting Muppet”. In both cases “Muppets” are “bad people!”

Equally, people in the companies have to accept responsibilities for their decisions, and as do people in government. The person or people making the decisions have to accept responsibility, otherwise we have unaccountability and possible anarchy. While diplomacy is important, in cases such as this, so is calling a spade a spade when you see one and not pussy footing or dancing around the core of a problem.

I could write a book or article on this subject, but I have to get back to work, carrying out some of the same basic principles noted above

Christopher Baxter on 04/09/2013 at 10:26

Re: Pentagon, Contractors Clash Over Profits

... and once the government has to pay for scope creep the good-idea fairy suddenly leaves the building.

Geoff Doyle on 03/26/2013 at 09:43

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